Over the last fortnight or so, we’ve been talking about the themes and factors which would help us to choose investments for 50 years.
It’s been a very interesting thought experiment.
Meanwhile, I’ve been reading Quality Investing: Owning the best companies for the long term.
It’s a book complied by AKO Capital, a renowned quality investing firm.
It’s a veritable trove of actionable investment wisdom and insight, and to me it felt like I was being taken back to the basics of investment.
Back to the fundamental goal of looking at a big list of companies and trying to decide which ones are the best.
Hopefully this review of the book will help you to feel the same way.
If you split investing into two parts, you would try to find the best companies and the cheapest companies. Both sound simple, and are exceptionally complicated.
Price and quality are two primary metrics on which we can judge a company as an investment. Value investors focus on the former, quality investors on the latter.
In his lifetime, Warren Buffett transitioned from being a value investor to a quality investor, explaining that “it’s better to buy incredible companies at good prices than good companies at incredible prices”.
That is to do with one factor above all: compounding.
Compounding not just of dividends and capital returns from the investor’s perspective, but also within the company itself.
Finding companies that deliver stable, long term, and above-average growth allows the business itself to compound through benchmark-beating returns on capital invested.
The book Quality Investing is probably one of the best books out there for helping us try and identify such companies.
Here’s a key stat. Buffett has made 84 of his 85 billions since he turned fifty (in 1980).
That’s compounding. He is a quality investor, and time is his number one investment strategy.
Quality investing without patience is important. The point of these companies is that over time, their compounding power outweighs any shorter term trends, fashions, fads (or Feds!).
Unilever’s share price, since 1968
What you can see is that for long-term investors, compounding means that the vast majority of your returns come in the most recent ten years.
6% per year gets you 79% after one decade, 474% after three decades, and a whopping 1,742% after 50 years.
L’Oréal, the French cosmetics giant, has averaged over 6% growth in its business for the last 20 years.
The share price has grown at a compound annual growth rate of 11% in the same period though, including dividends, beating the market five-fold in the same period.
11% compounded over the same ten, 30, and 50-year time frames gets you a return of 184%, 2,184, and 18,356% respectively – 18,356%!
When people advocate buy and hold investing, or investing for the long term, they can only be referring to quality investments, where compounding is a major force.
The book looks at various factors for identifying quality companies, including the many case studies. it tries to break things down into the kinds of things they look for. Durable advantages.
Quality companies can’t rely on a product or a partnership or a trend or fashion. Such things are liable to change.
Instead, they try and identify things which supersede the economic cycle, and the competitive environment in which they operate.
One I liked was “friendly middlemen”, where workers between the company and the customer are incentivised to sell a certain company’s product.
Situations where a trusted party, such as a dentist, wants to provide the highest quality service regardless of price (the customer pays), they are incentivised to go for the top-of-the-range products.
Another company, Geberit, is a specialist in loos, flushing systems and pipes, and has been for decades. Customers want reliability and a good price. Geberit’s key advantage is that it offers plumbers free training on how to install and repair its products.
Plumbers seek quality products that are unlikely to break, but unlike the end consumer are insensitive to price (again, because it’s the customer who pays).
Customers trust their expertise, and so having a global army of plumbers who are trained in dealing with your products makes Geberit’s the products of choice for plumbers everywhere.
By championing ease of installation and lifetime reliability, Geberit aids plumbers’ reputation.
It also operates counter-cyclically. During the financial crisis, it stepped up its training programme offerings, as economic slowdown left many plumbers with extra time on their hands. This turned a crisis into an opportunity, and has paid dividends ever since with the company improving operating margins and gaining market share consistently.
The book also has an interesting chapter on the challenges of being a quality investor.
I enjoyed reading about the challenge of just being boring, and doing very little. As long-term owners of companies everyone has heard of, with holding periods of decades not years, quality investors make few trades and watch whole trends and cycles come and go.
They are not exactly intrepid explorers, searching the markets for undiscovered gems. Nor are they shrewd portfolio managers, balancing risk and reward against the current macro climate.
This leads to bouts of short-term underperformance, and it can be quite psychologically taxing, watching others jump on the latest bandwagon and see immediate success.
Identifying which trends are fleeting and which are here to stay is hard to do.
Differentiating between cyclicality and quality is a difficult challenge too. A company might be growing margins, sales and market share year after year, but figuring out whether its competitive advantage is durable or if it’s just the beneficiary of a multi-year tail wind is what leads to many mistakes in quality investing.
For me though, the most interesting insight from the book was this. That people perennially undervalue quality.
Here’s a list of three classic quality investments.
Unilever, Kellogg’s and Coca-Cola. Three companies with incredible history of earnings and dividend growth, strong defensive moats, long-term management and other advantages aplenty.
They trade on price-to-earnings (P/E) ratios, after ten years of excellent returns, of 22x, 25x, and 20x. You’d think it would be higher.
Drawdowns are much lower than for most companies too, with only Coca-Cola falling more than 20% even in the turmoil of March of this year.
The authors of Quality Investing propose a theory. That most investors think “Yeah, yeah, we get it, they’re great but everyone already knows that. I want to find the undiscovered gems!”
The idea of investing as the pursuit of undiscovered gems leads most investors to overlook companies everyone knows are brilliant.
What quality investors like AKO Capital realise is that there is a double bluff in play.
Saying that quality companies are even greater than most people realise is just the same as saying another company isn’t as bad as everyone thinks (value investing).
And most people also think “Oh, yes, sure they are great companies but they’ve been on such a great run already, so I’ll wait and buy when they have an inevitable rough patch.”
The book though, argues that such a patch will rarely come for truly high-quality companies.
That’s because in times of turmoil (as has happened this year) companies with strong balance sheets, reliable earnings and sensible management do better – aka, quality companies will not suffer the same dips as overhyped tech and growth companies.
As such, you will rarely get a great opportunity to buy such companies. Rather, they trade in narrow P/E ranges for the most part, always great companies at good prices, rather than good companies at great prices.
If you can accept that deal, then you can begin compounding rising dividends and rising returns on retained capital too.
If you can take that bet, then you are a quality investor.
I myself can’t decide how I feel about this.
The problem is that their arguments spoke quite directly to me, as I do view most quality companies as having had an inordinately good decade or so.
As I explained in a previous piece, such companies have taken on the role of bonds – low-risk, stable sources of income – while interest rates have been so low. This has made these “bond proxies” unusually popular, and so while I do agree with them that in the most part, people undervalue quality, I wonder whether it’s quite so true this time.
This is true of almost every company in most sectors, but here too it’s significant that rising interest rates would reverse this trend.
For an example, here’s the share price of Unilever again. But with its net income (red) and P/E ratio beneath. What you can see is that while the share price has done brilliantly for two decades, it has rarely stepped out of line in terms of its P/E ratio or “multiple”. Earnings expansion is primarily responsible for its growth.
What’s more, its annual dividend per share was 12.5p in 1999, 52.2p in 2007, and 142.76p in 2019. Reinvested, the total return starts to look pretty phenomenal.
And things would look even better if you’d bought in 2001 instead of 1999 too.
Quality Investing is all about giving you the analytical tools to find quality companies. As a book, I like it. They hired a writer (Lawrence Cunningham) who’s done a good job of making it readable and interesting. A topic like this in manual form really risks straying into textbook territory, but that’s absolutely not the case here.
I can see myself returning to this on a nearly annual basis.
Because it felt to me that this book was helping me to understand the most fundamental part of investing – identifying the best companies, which have cultures, philosophies or business models that have the best chance to grant them lengthy outperformance in their sector.
Not just who’s grown revenues the most in the first few years, or who’s got the most popular product this year.
I’ve always been most fascinated by the pursuit of equity analysis within investment. Thinking about what makes one company better than others (and then putting your money where your mouth is) – for me, that’s a large part of why I find this field so interesting and continually rewarding.
I heartily recommend you all to go away and read this book, but if not, I hope this review has helped to stimulate a few thoughts about quality investing.
Meanwhile, if you’re not convinced, and would like to take a closer look at value investing as a strategy (and a very compelling one at that), then you can do so here.
All the best for now and have a great weekend.
Editor, UK Uncensored